Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Wednesday, October 31, 2012

When is it Time to Take a Vacation?

46 comments:

I think it's clear that by intellectual rigour he basically means intellectual honesty. I assume you're insulting Yglesias because, he is not an economist and is not up with all the rigorous techniques used in modern economics. But I think it's clear that what Yglesias is commending is to shift one's viewpoints on the basis of evidence (assuming this is what's going on what Kocherlakota). Whether the evidence justifies such a shift in position is an empirical question (which Yglesias of course answers in the affirmative), but I took the meaning of the post to be about how intellectually great it is to be open to changing one's fundamental views on evidence.

I don't understand your comment, so I'll tell you what mine means. Replace "I" with "Yglesias," and "brain surgeon" with "Kocherlakota." Yglesias simply does not have the expertise to tell the difference between a hero of rigor and a bad economist. To have someone called a "hero of rigor" is very funny in itself. To have Yglesias call Kocherlakota a "hero of rigor" makes me giggle every time I think of it.

I was suggesting that I don't think economics is either as complicated or as scientifically rigorous as brain surgery. As for being a hero of rigor, I think I prefer Yglesias's assumption that the change was in good faith as opposed to your assumption that the change represents some kind of sellout. Wouldn't figuring out the motives of an economist be behavioral economics, which would obviously be beyond the comprehension of either you or Yglesias?

"I don't think economics is either as complicated or as scientifically rigorous as brain surgery."

I have never done brain surgery, but I'm willing to assert that economics is MUCH more complicated than that. It isn't always as scientific as it might be, but that's the fault of some of the practitioners.

"Wouldn't figuring out the motives of an economist be behavioral economics, which would obviously be beyond the comprehension of either you or Yglesias?"

1. No, trying to figure out Kocherlakota is a whole field of study unto itself.2. I actually do know about behavioral economics. That's not so hard to figure out.

I guess I should be less disdainful of economics even though I view it as a profession that has failed pretty spectacularly the past couple of years. And I will concede that it is plenty complicated. So was alchemy.....

And implicit in your argument was a appeal to authority. Yglesias is unqualified to discuss a Federal Reseve Board member because he is not an economist. Moreover, it is discussing the change in approach by a Federal Reserve chairman, which Yglesias, as a reporter, is arguably more qualified to discuss than a macro economist. Now if you are arguing that you do not need particular expertise to discuss a change in approach by a Federal Reserve chairman, then Yglesias is perfectly qualified to discuss Kocherlakota.

Also, just because someone used to hold a view you hold and now doesn't doesn't make them a sell out or mean they have been corrupted for some unkown reason.

1. You're right that Yglesias lacks qualifications. He knows about as much formal economics as you (apparently) do. He could learn it on his own though. But he hasn't as demonstrated by what he writes. He wouldn't know good policy from bad policy, and thus I don't think we should pay attention to what he writes.

2. "...just because someone used to hold a view you hold and now doesn't doesn't make them a sell out or mean they have been corrupted for some unkown reason."

And, sorry, but monetary policy is really quite simple. When inflation is too high, you want to slow down the economy. When inflation is too low, as it's been the past four years, you need more monetary stimulus.

Your first problem is that you cannot even comprehend the above. Your second problem is that b/c your training gives you no advantage over Yglesias in terms of analysis, you pretend like you're doing rocket science. But really you just don't understand your own field.

1. I think Kocherlakota used to be worried that QE2 was generating unnecessary inflationary risks; that it would not be effective in boosting output; that despite high employment the economy was somewhere close to its potential output.

2. I think he has observed his predictions about inflation fail to materialize, despite an improving economy; he has been convinced by recent research arguing that the output gap is large; he has probably observed reactions in the equity and fixed income markets indicating that fed asset purchases have positive impacts on expected growth and inflation; he found Woodford's arguments for an NGDP target persuasive. In my opinion, all these things (and probably some others I'm overlooking) have led him to question his earlier model of how the world works, and to revise it.

There is nothing in the data between old Kocherlakota and new Kocherlakota that provides any convincing evidence for the new Kocherlakota position. The labor market is puzzlingly weak, in spite of massive Fed intervention. There is no serious theory to tell you how QE works, and the empirical work on the subject is poor. Woodford, who you mention, does not think QE is useful. The fact that you haven't seen the big inflation yet doesn't mean it can't happen.

I'm aware that you don't find the evidence convincing; but there are a lot of people who do. I'm suggesting Kocherlakota is one of those people. Explaining his behavior does not require implying that his ambition is overcoming his good judgement. It's much simpler to assume he really does find the evidence convincing.

"It's much simpler to assume he really does find the evidence convincing."

Not for me. When I see a smart person doing what seems to be stupid things, I assume that person is not telling me something. The "lot of people" you mention can be forgiven for not knowing any better, but Kocherlakota should know better.

"The fact that you haven't seen the big inflation yet doesn't mean it can't happen." True, but it calls for a model based explanation: why have four years of expansionary policies not led to high inflation, what delays the response? The Keyensian explanation is the liquidity trap. What's yours?

If I understood your previous post correctly you prefer the Fed reacting to actual inflation, not the forecasted inflation.

"What empirical evidence do you have that we are going to have big inflation"

The situation we are in (a large stock of excess reserves in the financial system, with interest paid on those reserves) is unprecedented. Thus, there is no data to go on - no empirical evidence. All we have is theory. I think the theory tells us that the potential is there for a higher inflation rate. I wouldn't stake my life on it, though. But that's the risk the Fed is facing.

Keynesians don't own the liquidity trap. With a large stock of excess reserves and interest paid on those reserves, if the Fed swaps reserves for government debt, that is irrelevant. But if the Fed fails to increase the interest rate on reserves when financial institutions become more reluctant to hold those reserves, we will get more inflation. I think that's what they will do.

"But if the Fed fails to increase the interest rate on reserves when financial institutions become more reluctant to hold those reserves, we will get more inflation. I think that's what they will do."

That is a very different claim from stating that there will be high levels of inflation that the Fed will be unable to control. Your view allows that the Fed could contain inflation (by raising the IOR), but will choose not to, because they believe that committing to higher inflation in the short run will bring the economy closer to full employment.

That's pretty much it, though I would put the last couple of lines differently. I don't like using the words "full employment," as I think they are meaningless.

There are two reasons why the Fed won't control inflation by increasing the interest rate on reserves:

1. They'll want to reverse the policy they have executed. That will involve first selling assets outright, or doing reverse repos, then increasing the interest rate on reserves - much later. That won't work, as QE did not work on the upside, so it won't work on the downside either.

2. Raising the interest rate on reserves will involve a tough choice, and I don't think this FOMC has the stomach for tough choices, particularly when we are still coming out of a recession. All of the language in Fed statements is preparing you for that.

I agree with you that the Fed will probably behave that way -- preferring to shrink their balance sheet before raising the IOR. But I see no reason that they will persist in that strategy if inflation begins to come unmoored. Even a cautious Fed will reassess the situation if there are 12 months of >5% inflation.

The important question, to me, is whether increased short-term inflation can help improve the labor markets. There are a lot of reasons to believe it can. There are obvious strong benefits to increased employment. There are also costs to increasing inflation. If we are in a situation where we can (in the short-term) trade higher inflation for higher employment, then there's a good argument to be made that the actions you envision the Fed taking will be beneficial to the economy and appropriate to fulfilling the Fed's dual mandate.

Given a lot of time the labor markets will adjust and rebalance themselves, but right now they only appear to be part of the way back. Until such time as labor market dynamics return to their historical norms, increasing prices to be closer to pre-crisis expectations has the potential to add to real growth.

How do you know that 2% inflation is not enough to deflate existing nominal debts at the appropriate rate? You seem to want a rate of inflation that would have been unanticipated in the past, and a redistribution of wealth from lenders to borrowers. I assume you are not worried about the lenders. Why not?

You mentionned that the current situation is unprecedented and therefore there is no data regarding the risk of high inflation. What do think about Japan? A financial crisis, followed by low inflation, low interest rates, and large excess reserves for a long long time...

I do want a rate of inflation that would have been unanticipated in the past, and yes, I expect that to redistribute wealth from lenders to borrowers. My view is that the current price level is well below where people would have expected it to be a few years back, prior to Lehman going under, which I'm using as a marker for the beginning of the acute phase of the crisis.

For example, over a fairly long time span, from the beginning of 2000 until the collapse of Lehman, inflation averaged about 3%. I'm not sure what your preferred metric is for measuring inflation expectations, but lets say for the sake of argument that prior to the Lehman event, expectations for long-run inflation were about 3%. Large swathes of the economy were implicitly dependent on that 3% annual price increase. Since then inflation has averaged about 1.6%, and expectations into the distant future are under 2%. The low current price levels (relative to past expectations) represent a transfer from borrowers to lenders. I just want to reverse that transfer. Since some portion of the debt has rolled over in the past 4 years, I don't even want to fully reverse the transfer. But I do think partially reversing this price expectations gap will benefit borrowers, reduce the real debt overhang, and encourage more hiring.

There is a bit of a burst in inflation before the financial crisis. If you go back to the beginning of 1997, and look at the 2% price level path, you'll see that we're currently right on it (or a little above with the last observation). See the second chart in this post:

Why focus on 2% inflation? That's the Fed's explicit goal, and you could have figured out that was the Fed's implicit goal before they announced it.

I think it's hard to make the case that we have to make up for some past redistribution. You claim that inflation expectations are low, but the last time I looked the TIPS breakeven rates were about where they were prior to the financial crisis. It looks like inflation is about right and expected to stay that way (though I have argued that trust in the Fed in this respect may be misplaced).

I have to disagree with your conclusions regarding historical inflation and the clarity of the Fed's goal.

Below is a list of average inflation over a range of different 10 year periods. At no point does any 10 year period have significantly below 2.5% inflation. I'm not sure why someone looking at historical inflation prior to the crisis would conclude that 2% was the Fed's target. A range of 2.5 - 3 percent would be a reasonable estimate. If you include data from the 80s the range would only go higher. The fact that we are on a 2% trend line now is indicative of just how far below expectations we have fallen relative to historical norms.

Apologies -- I noticed after putting those numbers together that you were using PCE data rather than CPI data (which makes a larger difference than I realized). Historical PCE inflation is close to 2% (a bit higher).

But regardless of which series you use, inflation over the past 4 years is significantly below the prior trend.

I honestly don't think I am. PCE inflation since the crisis is below 1.4%. Can you find me another 4 year period in that range any time since the Fed began targeting inflation? Pick any dates you like, the past four years are an outlier. Or is it my use of post-Lehman inflation as a benchmark that you object to? It doesn't seem like cherry-picking to compare post-crisis inflation with pre-crisis inflation.

See that big bulge, with the peak in mid-2008? That's from the runup in commodity prices prior to the financial crisis, and then the subsequent crash. You're free to use the peak in that bulge as a base period, but that's not going to convince me.

Ah, I see your point ... you see the deflation in late 2008 as a one-time event that doesn't affect the long-term trend. Ok, fair enough, and I don't think I can make the same point if I don't include the deflationary period in my numbers. I'll mull this over more later ... for now I have to go home and try to ignore the exit poll hype.

I don't know if it's too late to come back to this thread, but I've been thinking about this issue if you're interested in continuing the discussion.

I think earlier I was mistaken in trying to make the story only about the price level. In the balance-sheet recession story, really the important indicator is nominal income, not nominal price. Prices are part of the story, but so is productivity. For example, prices fell below expectations in the mid-to-late 90s, but I would never make the argument that monetary policy should have been easier. Why? Because productivity was exceeding expectations by even more.

If we reframe the discussion in terms of nominal income the problem with the past few years becomes even clearer. I'm not sure what metric you'd prefer to use ... I calculated quarterly per-capita nominal GDP. I removed recessionary periods to avoid cherry-picking. Average per-capita NGDP growth during non-recessionary quarters from 1990 - 2007 was about 5.5%. Average per-capita NGDP growth since we exited the 2007-2009 recession has been just below 4.0%. Given this, do you still think it is implausible that moving nominal income back towards trend could help improve the labor market?